Business (9609) | Business finance

Study Notes: Business Finance (AS Level)

Welcome to the world of Business Finance! Don’t worry if numbers aren't your favourite thing—this chapter is less about complex accounting and more about understanding how a business gets, manages, and spends money. This knowledge is vital because finance is the fuel that keeps every business running, growing, and surviving!

We will cover the essential topics of needing money, finding money, managing cash flow, understanding costs, and planning for the future (budgeting).

5.1 The Need for Business Finance

Every business, regardless of size, needs money (finance) to achieve its objectives.

Reasons Businesses Need Finance

Businesses require finance for three main stages:

• Start-up: To buy essential non-current assets (machinery, buildings) and cover initial running costs before sales revenue begins.
• Growth/Expansion: To purchase new capacity, develop new products (R&D), or enter new markets.
• Survival/Working Capital: To cover day-to-day operations, ensuring the business can pay suppliers and employees even if sales are slow.

The Crucial Distinction: Cash vs. Profit

This is a common point of confusion, but it’s critical for success in this topic!

Cash is the actual money in the bank (or hand). It is needed to pay immediate debts. A business can be profitable but still run out of cash (a situation called cash flow crisis).

Profit is the revenue left over after all costs have been deducted over a period of time. It is a measure of long-term success, but it doesn't mean cash is immediately available.

Analogy: Think of a car journey. Profit is like the trip meter (how far you’ve driven over the year). Cash is the current level of fuel in the tank (do you have enough to drive today?).

Failure due to lack of finance can lead to:

• Bankruptcy (for sole traders/partnerships with unlimited liability).
• Liquidation (winding up a company and selling assets to pay debts).
• Administration (temporary control by experts to try and save the company).

Working Capital (The Financial Engine)

Working capital is the finance needed for the day-to-day running of the business.

Formula:
Working Capital = Current Assets – Current Liabilities

• Current Assets (CA): Assets expected to be turned into cash within 12 months (e.g., inventory, cash, trade receivables—money owed by customers).
• Current Liabilities (CL): Debts due to be paid within 12 months (e.g., bank overdrafts, trade payables—money owed to suppliers).

Working capital management involves handling trade receivables (getting customers to pay faster) and trade payables (delaying paying suppliers, carefully).

Capital vs. Revenue Expenditure

1. Capital Expenditure (CapEx): Spending on non-current (fixed) assets that will last for more than one year and help the business earn revenue in the future. (e.g., buying a new factory, purchasing expensive machinery).

2. Revenue Expenditure (RevEx): Spending on items consumed in the normal course of business or within a year. These are the day-to-day running costs. (e.g., raw materials, wages, rent, utility bills).

5.2 Sources of Finance

Where a business gets its money depends heavily on its type of ownership (e.g., sole traders have limited options compared to Public Limited Companies).

5.2.1 Internal Sources of Finance

Internal sources come from within the business itself. These are usually the cheapest and most flexible options.

• Owners’ Investment: Money injected directly by the owners (e.g., a sole trader using personal savings).
• Retained Earnings (Ploughing back profit): Profit kept back by the business to be reinvested. (Did you know? This is often the largest source of long-term finance for established companies).
• Sale of Unwanted Assets: Selling items that are no longer needed (e.g., old computers, unused vehicles).
• Sale and Leaseback: Selling a non-current asset (like a building) to a financial institution and immediately renting (leasing) it back. This raises a large sum of cash quickly, but future rent payments become a fixed cost.
• Working Capital Management: Improving efficiency, such as reducing inventory levels.

5.2.2 External Sources of Finance

External sources come from outside the business. These often involve borrowing or giving up a share of ownership.

A. Debt Finance (Borrowing): Must be repaid, often with interest.

• Bank Overdraft: Short-term, flexible borrowing allowing the bank balance to go below zero. Very high interest rates. (Short-term)
• Bank Loans/Mortgages: Fixed sums borrowed for a set period. Mortgages are secured against property. (Medium/Long-term)
• Debentures: Long-term debt certificates issued by companies to raise large sums, usually fixed interest.
• Leasing/Hire Purchase: Allows the business to use assets without buying them outright. (Medium-term)
• Debt Factoring: Selling trade receivables (customer debts) to a factor company for immediate cash (usually at a discounted rate).
• Trade Credit: Delayed payment offered by suppliers (e.g., "30 days to pay"). Effectively an interest-free loan if managed well. (Short-term)

B. Equity Finance (Selling Ownership):

• Share Capital: Money raised by selling shares to the public (PLCs) or private investors (Ltds). This dilutes ownership control but never needs to be repaid.
• New Partners: For partnerships, bringing in new members who inject capital.
• Venture Capital: Investment by specialists in high-risk, high-growth potential businesses, usually involving taking a significant shareholding.
• Crowd Funding: Raising small amounts of money from many people, often via the internet.

C. Other Sources:

• Government Grants: Financial aid, often tied to specific activities (e.g., R&D, locating in a depressed area). Usually does not require repayment.
• Micro-finance: Small loans provided to entrepreneurs in developing countries who lack collateral.

5.2.3 Factors Affecting the Choice of Finance

Choosing the right source depends on many factors. Use the simple acronym C. F. U. L. D. to remember the key points:

1. Cost:
 • What is the true cost? (Interest rate, administrative fees, dividends). Equity finance has a "cost" of lost control and future dividends.

2. Flexibility:
 • How easy is it to repay early, change terms, or increase the amount?

3. Use:
 • Is the source suitable for the *purpose*? Short-term needs (like paying wages) should use short-term finance (overdraft); long-term assets (like machinery) should use long-term finance (loans or shares). This is called matching.

4. Loss of Control:
 • Does the source mean giving up ownership? (e.g., share capital means owners lose a proportion of control and future profits).

5. Debt Level:
 • How much debt does the business already have? Taking on more debt (higher gearing) increases risk.

5.3 Forecasting and Managing Cash Flows

A business needs to forecast its cash position to ensure it has enough liquidity (cash) to meet short-term obligations.

5.3.1 Cash Flow Forecasts

A cash flow forecast is an estimate of the expected cash inflows and outflows over a future period (usually monthly).

Purpose:

• To predict periods of cash deficit (shortages) so the business can arrange an overdraft or loan in advance.
• To support loan applications (banks want to see realistic forecasts).
• To measure performance later by comparing the forecast to actual cash flow.

The Interpretation: Calculating Balances

To calculate the monthly balances, you need these three steps:

1. Net Cash Flow = Total Cash Inflows – Total Cash Outflows
2. Closing Balance = Opening Balance + Net Cash Flow
3. The Opening Balance for the next month is the previous month's Closing Balance.

Example: If you start January with \$100 (Opening), bring in \$500, and spend \$600, your Net Cash Flow is -\$100. Your Closing Balance is \$100 - \$100 = \$0. The Opening Balance for February is \$0.

Methods of Improving Cash Flow

If a forecast predicts a cash deficit, management must act quickly:

To Increase Cash Inflows:

• Speed up the collection of trade receivables (offer early payment discounts).
• Sell off inventory quickly (even if at a discount).
• Find short-term external funding (e.g., bank overdraft or debt factoring).

To Decrease Cash Outflows:

• Delay payment to trade payables (suppliers), without risking relationships.
• Reduce inventory levels (adopting a Just-In-Time approach).
• Delay planned CapEx (postpone buying new machinery).

5.4 Costs and Break-Even Analysis

Accurate costing is essential for setting prices, controlling expenditure, and making strategic decisions (like accepting a special order).

5.4.1 Different Types of Costs

Costs can be classified in two key ways:

A. By Behaviour (How they change with output):

• Fixed Costs (FC): Costs that do not change with the level of production or sales. (e.g., rent, manager salaries, insurance).
• Variable Costs (VC): Costs that change directly and proportionally with the level of production or sales. (e.g., raw materials, piece-rate wages).

B. By Traceability (How they relate to a specific product):

• Direct Costs: Costs that can be directly identified with a unit of output (the materials and labour used to make *that specific product*). (e.g., wood for a chair, assembly worker wages).
• Indirect Costs (Overheads): Costs that cannot be directly linked to a specific product (fixed costs often fall here). (e.g., factory lighting, office administration).

5.4.2 Approaches to Costing: Full vs. Contribution

1. Full Costing (Absorption Costing)

This method allocates *all* costs (both direct and indirect, fixed and variable) to the product. It calculates the full cost per unit.

• Usefulness: Necessary for financial reporting and setting long-term prices to ensure all overheads are covered.
• Limitation: It can be arbitrary (difficult to decide how much factory rent to allocate to one unit of product) and doesn't help with short-term decision-making.

2. Contribution Costing (Marginal Costing)

This method only looks at the variable costs associated with a product. The fixed costs are covered by the total contribution of all sales.

Contribution: The amount each unit sold contributes towards covering the total fixed costs and then generating profit.

Formula:
Contribution per unit = Selling Price – Variable Cost per unit
Total Contribution = Total Revenue – Total Variable Costs

• Usefulness: Excellent for short-term decisions, especially accepting special orders or deciding which products to focus on (e.g., if a special order covers its variable costs, it increases total contribution and thus, overall profit, even if the price doesn’t cover *all* fixed costs).
• Limitation: Does not give a full picture of long-term profitability as fixed costs are ignored in unit calculation.

5.4.4 Break-Even Analysis (BEA)

Break-even analysis determines the level of sales a business needs to make in order to cover its total costs (where Total Revenue = Total Costs).

Importance: It helps managers determine risk, set prices, and forecast required output levels.

Key Calculations:

1. Break-Even Output (Units):

$$ \text{Break-Even Output} = \frac{\text{Total Fixed Costs}}{\text{Contribution per unit}} $$

2. Margin of Safety (MOS): The amount by which current output exceeds the break-even output. It shows how far sales can drop before the business starts losing money (measure of risk).

$$ \text{MOS (Units)} = \text{Actual Output} - \text{Break-Even Output} $$

3. Target Profit Output: If a business wants to achieve a certain level of profit.

$$ \text{Target Output} = \frac{\text{Total Fixed Costs} + \text{Target Profit}}{\text{Contribution per unit}} $$

Uses and Limitations of BEA

• Use: Simple to understand; guides pricing decisions; crucial for new businesses to determine financial viability.
• Limitation: Assumes fixed costs and variable costs behave perfectly linearly (which they don't always); assumes all output is sold; ignores changes in efficiency and quality.

5.5 Budgets and Variances

Budgeting is a financial plan that predicts future revenues and expenditures over a period of time.

5.5.1 The Meaning and Purpose of Budgets

A budget is a detailed financial plan for the future. It converts business objectives into specific, measurable financial targets (often derived from SMART objectives).

Main Purposes and Benefits:

• Planning: Forces managers to anticipate problems and plan for the future.
• Control & Monitoring: Provides a standard against which actual performance can be measured.
• Allocation of Resources: Ensures departments only spend what they have been allocated.
• Motivation: Can motivate staff if the budget targets are realistic and achievable.
• Coordination: Ensures all departments work towards the same financial goals.

Drawbacks of Budgets:

• Budgets can be inflexible if the market changes rapidly.
• If targets are set too high, they can demotivate staff.
• They can lead to unnecessary spending (departments use up the budget so it isn't cut next year).

Types of Budgeting

1. Incremental Budgeting: Based on the previous year's budget, with a small increase (increment) for inflation or growth.  Benefit: Quick and simple. Drawback: Assumes current spending is efficient; encourages wastage.

2. Flexible Budgeting: Budgets are allowed to change if the level of output or sales changes.  Benefit: More realistic and useful for performance comparison. Drawback: More complex to calculate.

3. Zero Budgeting (ZBB): Every department starts with a budget of zero. Managers must justify every single item of expenditure from scratch each year.  Benefit: Forces managers to review all costs and allocate resources efficiently. Drawback: Extremely time-consuming; can lead to short-term focus.

5.5.2 Variances (Measuring Performance)

A variance is the difference between the planned budget figure and the actual result.

Interpretation of Variances:

1. Favourable Variance (F): When the actual result is better than the budgeted result.  • *Example:* Actual revenue is higher than budgeted, or actual cost is lower than budgeted.

2. Adverse Variance (A): When the actual result is worse than the budgeted result.  • *Example:* Actual revenue is lower than budgeted, or actual cost is higher than budgeted.

Calculation and Interpretation:

$$ \text{Variance} = \text{Actual Result} - \text{Budgeted Result} $$

Note: When calculating, if the result for COSTS is positive, it is Adverse (you spent too much). If the result for REVENUE is positive, it is Favourable (you earned too much).

The interpretation of variances is more important than the calculation itself. Management must analyse why a variance occurred (e.g., adverse labour cost variance due to unexpected wage increase or inefficient workers?) and take corrective action.